From PLI S Course Handbook s4

From PLI’s Course Handbook Insurance Coverage 2008: Claim Trends & Litigation #14286

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MISREPRESENTATIONS AND OTHER WAYS TO LOSE YOUR COVERAGE

Ruth S. Kochenderfer Hunton & Williams, LLP

The author extends her sincere gratitude to Jeffrey Michael Cohen, Douglas Oppenheimer and Steven J. Brodie of Carlton Fields, P.A. Mr. Cohen graciously consented to allow the author to build upon their prior work entitled, “Your Cheatin’ Heart Will Tell On You: How Insurers Deal With Policyholder Misrepresentations.” This paper is largely based on that prior work and all credit belongs to them. Any errors are solely the author’s. Ruth S. Kochenderfer Counsel Hunton & Williams, LLP 1751 Pinnacle Drive, Suite 1700 McLean, VA 22102 (703) 714-7682 - Direct Dial (703) 914-8050 - Facsimile [email protected]

Ruth is a counsel in Hunton & Williams, LLP’s insurance coverage litigation practice group. She concentrates her practice on all manner of general liability insurance issues and has litigated numerous coverage cases. In her spare time, she enjoys spending time with her son, running, and, on rare occasions, running a marathon.

Ruth graduated from the University of Texas School of Law and is licensed to practice in Texas and Virginia.

2 MISREPRESENTATIONS AND OTHER WAYS TO LOSE YOUR COVERAGE

Ruth S. Kochenderfer Hunton & Williams, LLP 1751 Pinnacle Drive McLean, Virginia 22101 (703) 714-7682

3 I. INTRODUCTION

“O, what a tangled web we weave, When first we practise to deceive!”1

How does an insurance contract fall apart? One way is to trace it back to its roots and uncover a deception at its very beginning. Every insurance contract starts with an application. An application where an insurer asks for information upon which it will base its determination of whether to accept the risk. If it is later discovered that the applicant lied, the entire contract may come undone. This paper explores the contours of a policyholder’s misrepresentations and the relief available to an insurer when a misrepresentation is uncovered.

II. WHAT IS A MISREPRESENTATION?

The definition of a misrepresentation varies from state to state.2 Generally, a misrepresentation occurs when a policyholder provides false information to an insurer and that information is considered by the insurer in underwriting the risk.

Underwriting is a complex process with many variables. Depending on the nature of the policy, the insurer must decide what information is required to evaluate the risk and prepare an application that will elicit the necessary facts from the policyholder. Those facts are analyzed; the risk is evaluated; and a premium is calculated. If the facts are untrue, however, the policyholder has acquired protection for an inadequate payment or that have been unavailable at any price.

A. Was the Representation False?

A threshold issue is whether the policyholder’s representation or statement was untrue.

What questions did the insurer ask? The questions on the insurance application are crucial. They represent an underwriter’s judgment as to what information is required to evaluate the policy risk and set an appropriate premium. Detailed applications elicit

1 Sir Walter Scott, Marmion, canto vi, stanza 17.

2 See, e.g., N.J. Stat. § 17B:24-3(d) (authorizing an insurer to deny recovery for misrepresentations made on an application for insurance if such misrepresentations “materially affected either the acceptance of the risk or the hazard assumed by the insurer”); N.Y. Ins. Law § 3105(a) (“a representation is a statement as to past or present fact, made to the insurer by, or by the authority of, the applicant for insurance or the prospective insured, at or before the making of the insurance contract as an inducement to the making thereof. A misrepresentation is a false representation, and the facts misrepresented are those facts which make the representation false.”); Massachusetts Mut. Life Ins. Co. v. Allen, 416 P.2d 935, 940 (Okla. 1965) (“A misrepresentation in insurance is a statement as a fact of something which is untrue, and which the insured states with the knowledge that it is untrue and with an intent to deceive, or which he states positively as true without knowing it to be true, and which has a tendency to mislead, where such fact in either case is material to the risk.”) (internal quotations and citation omitted).

4 more information. Detailed applications also leave less opportunity for the policyholder to “misunderstand” what information is being solicited.

A policyholder’s responses to application questions may be assessed under an objective or subjective standard depending on the terms of the policy. Compare the following questions

 Are you aware of an act or omission that may reasonably be expected to be the basis of a claim against you?

 Have you completed the application to the best of your knowledge?

The first question is objective. The applicant may not later contend that such a question was misunderstood or that its response should be deemed insignificant.3 The second question, on the other hand, is subjective because it calls for the applicant’s opinion. It is far more difficult to show that an answer is false -- and thus a misrepresentation -- when it depends on an applicant’s state of mind.4

Omission is another component of falsity. An applicant’s failure to disclose facts that a reasonable person would consider important may mislead the insurer. Some courts have granted relief because the applicant omitted information. For example, in Lighton v. Madison-Onondaga Mutual Fire Ins. Co.,5 the court held that an applicant who is aware of circumstances which he knows would influence the insurer’s decision is required to disclose the facts, even though he was not asked. Lighton arose out of a fire loss. Prior to the issuance of the policy, there had been a “suspicious” fire. The insurer did not ask about any prior fires in its application, and the applicant did not inform the insurer about the prior fire. The court held, nevertheless, that “fraudulent concealment may void an insurance policy, even if the fact concealed was not one inquired into by the insurer.”6 However, most courts have concluded that the applicant has no duty to disclose information in the absence of a specific question.7

3 TIG Ins. Co. v. Robertson, Cecil, King & Pruitt, LLP, 2003 U.S. Dist. LEXIS 1481, 2003 WL 253167 at *3 (W.D. Va. 2003), aff'd, 116 Fed. Appx. 423 (4th Cir. 2004) (holding that an insured’s negative response to a question asking him whether he was aware of any wrongful act that might give rise to a future claim was false where “any reasonable attorney would know that stealing large amounts of money from clients would likely produce a claim”).

4 Parkerson v. Fed. Home Life Ins., 797 F. Supp. 1308, 1315 (E.D. Va. 1992), (“where . . . the insurer asks the insured to aver only that the representations are true to the best of the insured’s knowledge and belief, the insurer must clearly prove that the insured’s answers were knowingly false.”); see also Sterling Ins. Co. v. Dansey, 81 S.E.2d 446, 451 (Va. 1954) (finding that where answers in an application for insurance are stated to be true to applicant’s best knowledge and belief, an incorrect statement innocently made will not void the policy).

5 483 N.Y.S.2d 515 (N. Y App.Div. 1984).

6 483 N.Y.S.2d at 516 (citations omitted).

7 Allstate Ins. Co. v. Shirah, 466 So.2d 940 (Ala. 1985).

5 Additionally, a majority of courts have held that an insurer has the right to rely on the policyholder’s answers to questions in the application without having to investigate and verify the accuracy of those answers.8 If, however, an insurer is placed on notice that the application is incorrect, the insurer may be bound by what a reasonable investigation would have shown.9

B. Was the Misrepresentation Material?

The next issue is the one that is often critical to the analysis: whether the misrepresentation was material. Materiality is often defined by statute. In general, a misrepresentation is material if it would have influenced the insurer’s decision to issue the policy, to set the premium, or to determine the terms and conditions of the policy.10

The majority rule appears to be that materiality is measured by a subjective standard -- it depends on the effect truthful answers would have on that particular insurer, not a hypothetical “reasonable insurer.”11 For example, California determines materiality “solely by the probable and reasonable effect which truthful answers would have had on the insurer.”12 In some jurisdictions, the fact that an insurer has asked specific questions in an insurance application is often sufficient to establish materiality as a matter of law.13

8 See Admiral Ins. Co. v. Debber, 442 F. Supp. 2d 958, 967 (E.D. Cal. 2006); see also Merchants Fire Assurance Corp. v. Lattimore, 263 F.2d 232, 244 (9th Cir. 1959) (“[A]n insured may not escape the consequences of his deception by placing on the insurer the burden of investigating his verified statements.”); Commercial Life Insur. v. Lone Star Life Insur., 727 F.Supp. 467, 471 (N.D.Ill. 1989) (“[a]n insurance company has the right to rely on the truthfulness of the answers given by an insurance applicant, and the insured has the corresponding duty to supply complete and accurate information to the insurer.”).

9 Independent Fire Ins. Co. v. Arvidson, 604 So.2d 854 (Fla. App. 4 DCA 1992); Cox v. American Pioneer Life Ins. Co., 626 So.2d 243 (Fla. App. 5 DCA 1993); Swain v. Life Ins. Co. of La., 537 So.2d 1297 (La.Ct.App. 1989).

10 Ranger Ins. Co. v. Kovach, 63 F. Supp. 2d 174, 186 (D. Conn. 1999) (explaining that a misrepresentation is material when it “would so increase the degree or character of the risk of the insurance as to substantially influence its issuance, or substantially affect the rate of the premium.”) citing Davis Scofield Co. v. Agricultural Ins. Co., 145 A. 38, 40 (Conn. 1929); Evora v. Henry, 559 A.2d 1038, 1040-41 (R.I. 1989) (stating that a misrepresentation is material when it induces insurer to insure applicant when it would not otherwise have done so). In New York, New York Insurance Law § 3105 specifically governs representations by a policyholder in the insurance context. Section 3105(b) provides “No misrepresentation shall avoid any contract of insurance or defeat recovery thereunder unless such misrepresentation was material. No misrepresentation shall be deemed material unless knowledge by the insurer of the facts misrepresented would have led to a refusal by the insurer to make such contract.”

11 Robinson v. Reliable Life Ins. Co., 569 S.W.2d 28, 29 (Tex. 1978) (“[T]he principal inquiry in determining materiality is whether the insurer would have accepted the risk if the true facts had been disclosed.”).

12 Thompson v. Occidental Life Ins. Co. of California, 513 P.2d 353, 360 (Cal. 1973); Cal. Ins. Code § 334.

13 Thompson, 513 P.2d at 360.

6 In other words, where a specific question is asked, the answers to those questions are “deemed” material to the policy.14

A minority of jurisdictions determine materiality by an objective standard. An objective standard asks whether a reasonably careful and intelligent person would regard the misrepresentation as substantially increasing the chance of the hazard insured against so as to cause the application to be rejected, or the policy issued with different conditions or higher premiums.15 In New York, a statute provides that in determining “materiality,” “evidence of the practice of the insurer which made such contract with respect to the acceptance or rejection of similar risks shall be admissible.”16

C. Did the Insurer Rely upon the Misrepresentation?

As discussed above, an insurer is entitled to rely upon information provided by a policyholder in the application.17 Some jurisdictions go a step further and require the insurer to establish that it actually relied upon the policyholder’s application statements. 18 Other jurisdictions hold that reliance is not a prerequisite for denying a claim.19

As a practical matter, an insurer should consider introducing evidence of reliance because reliance may help establish materiality. Reliance may be proven by the testimony of the underwriter that the policy would not have been issued or that the terms would have been different if the application had not contained the misrepresentation.

14 See Admiral Ins. Co. v. Debber, 442 F. Supp. 2d 958, 967 (E.D. Cal. 2006) (citing Imperial Cas. & Indem. Co. v. Sogomonian, 243 Cal. Rptr. 639 (Cal. Ct. App. 1988)); Paul Revere Life Ins. Co. v. Pastena, 725 A.2d 996, 998 (Conn. App. 1999) (recognizing that statements made in an insurance contract, which are utilized in forming a policy, are generally considered material).

15 Bageanis v. American Bankers Life Assurance Co. of Florida, 783 F.Supp. 1141, 1145 (N.D. Ill. 1992) (“‘Materiality’ is determined by asking whether reasonably careful and intelligent persons would have regarded the omitted facts as substantially increasing the chances of the events insured against so as to cause a rejection of the application or different conditions, such as higher premiums.”); Wittner v. IDS Ins. Co. of N.Y., 466 N.Y.S.2d 480, 481 (N.Y. Ct. App. 1983) (“conclusory statement by an insurance company employee that the company would not have insured the applicant if it had known his or her true medical history is, in and of itself, insufficient to establish that a misrepresentation was material. Documentation, such as the insurance company’s underwriting manuals, rules or bulletins, which pertain to insuring similar risks, should be submitted.”).

16 N.Y. Ins. Law § 3105(c).

17 See supra at note 8.

18 Federal Kemper Life Assurance Co. v. First National Bank of Birmingham, 712 F.2d 459 (11th Cir. 1983) (Alabama law); World Ins. Co. v. Posey, 227 So.2d 67 (Fla. App. 4 DCA 1969) (“Proof of reliance upon a misrepresentation to the insurer’s detriment is essential if the insurer seeks to void the policy because of a misrepresentation in the application.”).

19 Northwestern Mutual Life Ins. Co. v. Iannacchino, 950 F.Supp. 28 (D.Mass. 1997).

7 D. Was There a Causal Connection between the Misrepresentation and the Loss?

Some states require a causal connection between the misrepresentation and the policyholder’s loss.20 In these states, even if the policyholder knowingly lied, the insurer cannot raise the misrepresentation as a basis for rescission or a defense unless the policyholder’s claim is caused by the misrepresented condition. The better-reasoned rule is that causation is not required, i.e., if the policyholder misrepresented a fact in the application, the insurer may rescind or deny the claim even if the misrepresentation is unrelated to the claim.21 Moreover, a material misrepresentation may be a basis for rescission even in the absence of a pending claim.22

E. Was the Misrepresentation Made Knowingly or Intentionally?

In most jurisdictions, an insurer is not required to establish that a misrepresentation was made knowingly or intentionally. Instead, those jurisdictions only require that the misrepresentation be false, material, and relied upon.23 For example, in Florida a non-intentional material misstatement in an application will prevent recovery by the policyholder.24 In New York, for instance, even an innocent misrepresentation, if material, is sufficient to allow the insurer to avoid the policy obligation.25 In these jurisdictions, the insured’s intent is irrelevant.

In contrast, some jurisdictions require the insurer to establish an intentional misrepresentation. Under Texas law, an insurer may rescind a policy only by proving the insured’s intent to deceive.26 Pennsylvania requires that the policyholder have acted in

20 See Ariz. Rev. Stat. Ann. § 20-1109; Ark. Code Ann. § 23-66305, 23-79-107(c).

21 Hinna v. Blue Cross Blue Shield of Texas, 2007 WL 3086025 (N.D.Tex. Oct. 22, 2007) (“an insurance policy can be avoided upon a finding that the misrepresentation was material to the risk without proof that the condition misrepresented contributed to the event that caused the loss.”); Bageanis v. American Bankers Life Assurance Co. of Florida, 783 F.Supp. 1141 (N.D. Ill. 1992) (“the fact that a potential insured did not die from the withheld ailment does not affect the materiality of the misrepresentation”).

22 Republic Ins. Co. v. Masters, Mates & Plots Pension Plan, 77 F.3d 48 (2nd Cir. 1996) (New York law).

23 Ratcliffe v. International Surplus Lines Insur., 550 N.E.2d 1052, 1057 (Ill. App. Ct. 1990) (holding that “it is unnecessary for the insurer to prove that a misrepresentation was made with the intent to deceive if it was material to the risk assumed”). See also Douglas v. Mutual Life Ins. Co. of N.Y., 191 So.2d 483 (Fla. App. 2 DCA 1966); Lash v. Allstate Ins. Co., 532 N.W.2d 869 (Mich. 1995); Ledley v. William Penn Life Ins. Co., 651 A.2d 92 (N.J. 1995).

24 Old Southern Life Ins. Co. v. Kirby, 522 So. 2d 424 (Fla. App. 1 DCA 1988) (“Under section 627.409(1), the misrepresentations or omissions need not be fraudulently or knowingly made by the claimed insured in order to void the policy if the misrepresentation or omission affected the insurer’s acceptance of the risk, or if the insurer would not have issued the policy, had the true facts been revealed.”).

25 Mutual Benefit Life Ins. Co. v. JMR Electric Corp., 848 F.2d 30 (2nd Cir. 1988).

26 Union Bankers Ins. Co. v. Shelton, 889 S.W.2d 278, 282-83 (Tex. 1994) (“By statute, a misrepresentation in an application for any type of insurance must be material in order to avoid the policy. The proposition that an insured's intent to deceive is likewise required is well established in the common law of this state.”)

8 bad faith or know that its representations were false for the insurer to obtain relief.27 South Carolina and Louisiana also require specific intent.28

Other states employ a hybrid approach. For example, in Arizona, if the application question calls for a specific factual response, e.g. “have you ever been sued?” the insurer is not required to prove intent to deceive when the answer is false. However, the insurer must prove intent to defraud when the policyholder misrepresents an opinion, e.g. “are you aware of an act or omission that may reasonably be expected to be the basis of a claim against you?”29

F. Does One Policyholder’s Misrepresentation Defeat Coverage for All?

Insurance applications are often prepared by and signed by one of several policyholders. Most of the policyholders, however, will never have seen the application nor will they be aware of a misrepresentation. This raises the issue of whether one policyholder’s misrepresentation will be imputed to all policyholders.

In California, the answer to the question is found in a statute. California Insurance Code Section 650 provides that rescission under the code “shall apply to all insureds under the contract, including additional insureds, unless the contract provides otherwise.” Based on this statutory provision, an insurer was allowed to rescind coverage for the innocent insureds because the corporation’s chief financial officer misrepresented material facts in the application.30

To protect innocent co-insureds, some policies contain a “severability provision.”31 A severability provision typically provides for the separate determination of coverage for each insured. This protects innocent insureds from losing coverage for acts of others that might otherwise bar coverage for the innocent insured.

For example, in In re HealthSouth Corp. Insurance Litigation, several insurers attempted to rescind D&O insurance coverage based on application misstatements after

(internal citation omitted).

27 Matininchek v. John Alden Life Ins. Co., 93 F.3d 96 (3d Cir. 1996).

28 Carroll v. Jackson National Life Ins. Co., 414 S.E. 2d 777 (S.C. 1992); Coleman v. Occidental Life Ins. Co., 418 So. 2d 645 (La. 1982).

29 Stewart v. Mutual of Omaha Ins. Co., 817 P.2d 44 (Ariz. App. 1991).

30 Federal Ins. Co. v. Homestore, Inc., 144 Fed.App. 641 (9th Cir. 2005). See also Shapiro v. American Home Assurance Co., 584 F.Supp. 1245 (D.Mass. 1984) (holding that because application, which the innocent directors never saw, asked if any director knew of facts which would lead to a claim, corporate president’s misrepresentations voided coverage for all).

31 Generally, there may be two types of severability of interest clauses in a policy: (1) severability of conduct, and (2) severability of application. A severability of conduct provision precludes the imputation of one policyholder’s wrongful conduct to other innocent policyholders. A severability of application provision provides that only those policyholders who were actually aware of a misrepresentation in an application would lose coverage under the policy.

9 former HealthSouth officers entered guilty pleas and admitted that they engaged in a scheme to misrepresent the company’s finances.32 The HealthSouth D&O policy included a “Representations and Severability” clause, which provided:

With respect to the declaration of statements contained in such written application(s) for coverage, no statement in the application or knowledge possessed by any Insured Person shall be imputed to any other Insured Person for the purpose of determining if coverage is available.

The court held that the severability provision “preclude[s] rescission as to all insureds regardless of their involvement in the alleged fraud.”33

Some courts have held that severability provisions do not necessarily prohibit rescission as to all insureds. For example, in TIG Insurance Co. of Michigan v. Homestore, Inc.,34 the policy provided as follows:

In the event that the Application, including materials submitted therewith, contains misrepresentations . . . which materially affect either the acceptance of this risk or the hazard assumed by the Insurer under this Policy, no coverage shall be afforded under this policy . . . for any Director or Officer who did not sign the Application but who knew on the inception date of this Policy the facts that were so represented, and this Policy in its entirety shall be void and of no effect whatsoever if such misrepresentations were known to be untrue on the inception date of the Policy by one or more individuals who signed the Application.

Homestore’s former chief financial officer pled guilty to conspiracy to commit insurance fraud in connection with the overstatement of the insured’s advertising revenue in securities filings. The same CFO had signed a renewal information application. That application required submission of the insured’s most recent 10-Q. The 10-Q filing that was submitted with the application included the overstatement in advertising income. After learning of the overstatement, an excess insurer brought an action to rescind the policy on the basis that the 10-Q on which it relied contained material misstatements. A trial court found that the misstatements allowed the insurer to rescind the policy, making it “null, void and of no effect whatsoever as to all insureds.”35

The insured entity in Homestore and several insured directors and officers argued that the policy should be void only as to those who signed the policy and non-signers with knowledge.36 The appeals court disagreed and affirmed the trial court’s decision,

32 308 F.Supp. 2d 1253 (N.D. Ala. 2004).

33 Id. at 1259.

34 40 Cal. Rptr. 3d 528, 530 (Cal. Ct. App. 2006).

35 Id. at 531.

36 Id. at 533-34.

10 finding that the plain language of the policy did not alter the statutory right to rescind as to all insureds. The court found that the “entire policy shall be void” language would have to be disregarded in the insured’s interpretation.37 The court further noted that policies with severability provisions were available, but Homestore did not purchase such a policy.38

As these cases reveal, the answer to the question of whether one policyholder’s misrepresentation will extend to all policyholders may hinge on whether a policy contains a severability clause and the precise wording of any such clause.

G. Are Materials Submitted with the Application Relevant to Misrepresentation?

Underwriting decisions often are made on the basis of information submitted with the application. For example, in TIG Insurance Co. of Michigan v. Homestore, Inc., an excess insurer issued a policy based, in part, on a 10-Q statement that contained an overstatement in advertising income.39

Policyholders have attempted to defeat an insurer’s claim of misrepresentation by contending that the information submitted with but not contained in the application was not a misrepresentation. For example, in National Union Fire Ins. Co. of Pittsburgh, Pa. v. Continental Ill. Corp.,40 the court held that the insurer could not raise misrepresentation in financial statements because the application merely asked that financial statement be attached and did not require that the policyholder acknowledge that the statements were part of the application and attest to their truth.

A different result was reached in Cutter & Buck, Inc. v. Genesis Ins. Co.41 In Cutter & Buck, the application required the policyholder to submit financial reports and a CPA letter with the application and declare that the statements in the application were true. The policy also stated that the insurer would rely upon the application and any materials submitted with it. These would be deemed “representations” upon which the insurer would rely. The policyholder did not attach the financial statements, but the

37 Id.

38 See also Fed. Ins. Co. v. Homestore, Inc., 144 Fed. App’x 641 (9th Cir. 2005) (reaching the same conclusion with regard to primary and other excess insurers); RLI Insurance Co. v. Castle Rock Industries, Inc., No. C 06-5904 JF, 2007 WL 2070302, *3 (N.D. Cal. July 17, 2007) (finding policy rescinded as to additional insured as well as named insured because separation of insureds provision simply clarified that the term “insured” when used in an exclusion referred only to the specific insured claiming coverage, but did not prevent rescission for misrepresentations in the application); Walbrook Ins. Co. v. Speigel, No. CV 91-1206, 1993 WL 580759, *5 (C.D. Cal. Aug. 6, 1993) (noting that misrepresentations are attributable to all insureds, even insureds without knowledge or insureds not involved in the application process).

39 40 Cal. Rptr. 3d 528, 530 (Cal. Ct. App. 2006).

40 643 F.Supp. 1434 (N.D. Ill. 1986).

41 306 F.Supp. 2d 988 (W.D. Wa. 2004).

11 insurer obtained them from the internet. The court held that the policyholder was on notice that these other materials would be considered in issuing the policy, therefore, their falsity would be considered misrepresentations entitling the insurer to rescind.

III. WHAT REMEDIES ARE AVAILABLE TO AN INSURER?

Various remedies are available to an insurer that discovers its policy was issued in reliance upon a policyholder’s misrepresentation.

H. May an Insurer Simply Rescind the Policy?

An insurer may unilaterally rescind a policy by declaring it void from the outset and returning the premium, as well as any interest, to the policyholder. Although the insurer may do this, it is unclear whether such an action actually relieves an insurer of its obligations under the policy.

Unilateral rescission is not available if a claim has been made under a policy. In Federal Insurance Co. v. Tyco International, Ltd, a New York state trial court determined that an insurer could not unilaterally rescind a policy, and that the insurer should pay defense costs until its rescission claim was proven and a court declared the policy void. 42 In Tyco, a former Tyco International, Ltd. CEO requested that an insurer defend him under D&O policies in a civil securities lawsuit and a criminal action filed against Tyco and its former directors and officers. In response to the tender, the insurer returned the premium and informed Tyco that it was rescinding the policy based upon material misrepresentations and omissions in the information relied on by the insurer in issuing the policy. In a subsequent declaratory judgment action, the trial court held that the insurer was not absolved from its defense obligation based upon its unilateral decision to rescind a policy. Instead, the insurer must defend the insured until a court determines that the policy is rescinded.

The decision was affirmed, in relevant part, in Federal Insurance Co. v. Kozlowski.43 The court recognized that upon discovery of a fraud that induced a party to enter into a contract, the party may effect a rescission by its own act or apply for rescission in a court of equity. However, the court found that rescission by notice may be used only when there has been no change in the parties’ respective positions from the time they entered into the contract. If claims have been asserted against a policyholder, then the status quo no longer exists and the right of rescission by notice is no longer available. The Kozlowski court explained that “[i]n such circumstances, a rescission by notice cannot, without legal sanction, have retroactive effect and serve to suspend, even temporarily, obligations that -- absent a basis for rescission -- have accrued under the policy.”44

42 784 N.Y.S.2d 920 (Table) (N.Y.Sup. 2004) (Table decision).

43 792 N.Y.S.2d 397, 401 (N.Y. App. Div. 2005).

44 Id. at 402. See also In re: Worldcom, Inc. Securities Litigation, 354 F. Supp.2d 455 (S.D.N.Y. 2005).

12 In light of these recent decisions, unilateral rescission may not be an attractive choice for an insurer.

I. May an Insurer Bring a Rescission Action?

An insurer may bring a rescission action or, alternatively, wait to be sued and counterclaim for rescission. There are risks to waiting. The incontestability period may lapse and compromise the insurer’s position. A policyholder may also argue that insurer waived its rights to rescind if an insurer delays before rescinding a policy. Because of this, it is probably in the insurer’s best interests to file a rescission action.

Another option for an insurer may be to bring an action for partial rescission. At least one court has allowed partial rescission of an insurance contact based on policyholders’ misrepresentations.45 In First American Title Insurance Co. v. Lawson, two of the three partners in a law firm were engaged in a “kiting” scheme where monies from one client trust account would be transferred to pay the obligations of another client. The third partner was wholly unaware of his partners’ actions. One of the partners involved in the scheme applied for professional liability insurance on behalf of the firm, and he represented on the application that he was aware of no actual malpractice claims or of any errors or omissions that could give rise to such a claim. This was blatantly false, given his knowledge of the kiting scheme as well as three grievances pending against him with the New Jersey Office of Attorney Ethics. After paying several claims, the insurer sought rescission of the contract. Although the lower courts granted complete rescission of the contract, the New Jersey Supreme Court determined that only partial rescission was appropriate, and that coverage should remain available for the innocent partner.46 The court explained that it “view[ed] the underlying policy as being sufficiently divisible in respect of each individual partner so that partial rescission is a permissible remedy on the facts before us.”47

J. May an Insurer Disclaim Coverage Based on a Misrepresentation?

Misrepresentation may also be raised as a defense to the policyholder’s coverage action without seeking rescission. This approach does not void the entire policy, it merely seeks to disclaim any duty to respond to a specific claim.

Misrepresentation is an affirmative defense. If misrepresentation is raised as a defense, an insurer is not required to refund the premium, which in some cases may be greater than the value of the claim. Additionally, if misrepresentation is raised as a defense, a policy’s incontestability clause will not apply because the insurer is only seeking to deny a claim as opposed to rescinding the entire policy.

45 First American Title Ins. Co. v. Lawson, 177 N.J. 125 (N.J. 2003).

46 Interestingly, there is no mention of a severability clause in Lawson. As discussed above, a severability clause might have provided coverage for the innocent policyholder.

47 177 N.J. at 144.

13 IV. WHAT DEFENSES ARE AVAILABLE TO THE POLICYHOLDER?

If faced with a rescission action or an allegation of misrepresentation, there are defenses available to a policyholder.

K. Has the Incontestability Period Expired?

There may be a time limit on the insurer’s right to rescind. Many states have enacted a two-year limit on an insurer’s right to rescind a policy because of a policyholder’s misrepresentation.48 The purpose of these statutes is to provide the insurer with an adequate time period to investigate the policyholder’s representations and to protect the policyholder from having to litigate a claim of misrepresentation long after the policy was issued. There are some exceptions to the rule. In some states, if the insured dies during the two year period, and the policy so provides, the policy never becomes incontestable.49 Other states allow rescission only for fraud after the incontestability period.50

L. Was the Application Attached to the Policy?

Many states have enacted statutes requiring the insurer to attach the application to the policy. One purpose of such a statute is to provide the policyholder with an opportunity to review the application and correct any mistakes. Generally, representations in an application not attached to the policy may not support an insurer’s claim of misrepresentation.51

M. Was the Misrepresentation a Result of an Insurance Agent’s Mistake?

Many insurance applications are completed by an insurance agent. A policyholder may contend that an agent was aware of information about a policyholder. It is generally recognized that notice to the agent at the time of the application is notice to the insurer, thereby precluding the insurer from alleging misrepresentation on matters known to the agent.52 To raise this defense, a policyholder must establish that the agent is

48 See, e.g., O.R.S. § 743.414 (2 years for health insurance policies); S.D. Codified Laws 58-17-15 (same); Va. Code Ann. §§ 38.2-3911 & 38.2.3912 (same).

49 Crow v. Capitol Bankers Life, 891 P.2d 1206 (N. Mex. 1995).

50 See, e.g., O.R.S. § 743.414 (“After two years from the date of issue of this policy no misstatements, except fraudulent misstatements, made by the applicant in the application for such policy shall be used to void the policy or to deny a claim for loss incurred or disability, as defined in the policy, commencing after the expiration of that period.”).

51 Horowitz v. Federal Kemper Life Assurance Co., 57 F.3d 300 (3d Cir. 1995) (Pennsylvania law) (noting that “Section 441 of Pennsylvania’s Insurance Company Law of 1921 . . . bars an insurer from using certain documents, including a policy application, as evidence of fraud against an insured unless they are ‘attached and accompany [ ] the policy.’”); Fredonia State Bank v. General American Life Ins. Co., 881 S.W. 2d 279 (Tex. 1994) (holding that an insurance company may not assert a misrepresentation defense based on misrepresentations in an application that was not attached to a policy).

52 Celtic Life Ins. Co. v. Coats, 885 S.W. 2d 96 (Texas 1994).

14 an agent of the insurer and not the agent of the policyholder or an independent agent. An insurance “broker” or independent agent is generally considered to be the agent of the policyholder.53

N. Has the Insurer Waived the Right to Assert Misrepresentation?

It is black-letter law that waiver is an intentional relinquishment of a known right or conduct which implies relinquishment of a known right. If the insurer, having full knowledge of the misrepresentation, continues to treat the policy as valid or continues to accept premiums, the insurer may be estopped to assert a misrepresentation defense or rescind the policy based on a misrepresentation.54

Some courts have concluded that an insurer is permitted a reasonable amount of time to investigate before waiver will bar a rescission claim. For example, California law requires that the party seeking rescission provide the other party notice “promptly upon discovering the facts which entitle him to rescind.”55 The California Insurance Code further provides that the right to rescind an insurance policy may occur at any time prior to the commencement of an action on the contract.56 Reading these requirements together, California courts have held that an insurer must seek rescission before an action on the policy and within a reasonable time from discovering an error in the policy.57

What is a reasonable time? In Admiral Insurance Co. v. Debber, a nine-month period was reasonable. The policyholder in Debber contested the insurer’s suit for rescission on the ground of a laches defense, arguing that the insurer’s delay in rescinding the policy caused substantial prejudice.58 The Debber court found that the insurer was entitled to a reasonable time to investigate and act upon its right to rescind, and a nine- month delay between the time the insurer learned the information that formed the basis of its right to rescission, and a seven-month delay between the time the insurer decided to seek rescission and actually filing the suit was not unreasonable.59

V. CONCLUSION

If a policy’s roots reveal that it is based on a deception, that deception may be a basis for voiding the policy. Many questions must be answered before that decision

53 Steele v. Jackson National Life Ins. Co., 691 So.2d 525 (Fla. App. 5 DCA 1997).

54 Johnson v. Life Ins. Co. of Georgia, 52 So.2d 813 (Fla. 1951).

55 Admiral Ins. Co. v. Debber, 442 F. Supp. 2d 958, 970 (E.D. Cal. 2006); Cal. Civ. Code § 1691.

56 Cal. Ins. Code § 650.

57 Admiral, 442 F. Supp. 2d at 970 (citing Cole v. Calaway, 140 Cal. App. 2d 340, 347-48 (1956)).

58 Id. at 969-70.

59 Id. at 970-71 (also citing cases finding three months, four months and one year delays reasonable).

15 should be made. It is the answers to those questions that allows an insurer to untangle the complicated web of misrepresentation.

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The author extends her sincere gratitude to Jeffrey Michael Cohen, Douglas Oppenheimer and Steven J. Brodie of Carlton Fields, P.A. Mr. Cohen graciously consented to allow the author to build upon their prior work entitled, “Your Cheatin’ Heart Will Tell On You: How Insurers Deal With Policyholder Misrepresentations.” This paper is largely based on that prior work and all credit belongs to them. Any errors are solely the author’s.